The Problem with Real Estate Commissions

Posted by nithi.vivatrat on January 19, 2009

You may be surprised by the how much real estate commissions are paid by consumers in a year — I know I was.   In 2007, US consumers spent nearly $80 billion (yes, that’s a “B”) on real estate brokerage fees.  The turmoil in the market is likely to put a dent in that — REALTrends believes that new and existing home sales in 2008 will be close to 5 million units, down from 5.65 million in 2007 and a sharp decline from mid-2008 forecasts — but even with, say, a 20% reduction, that’s still $64 billion in fees.

It’s common to see a commission rate on the order of 5-7% of the final sale price of a property split in some fashion between the seller’s and buyer’s brokers. A fixed commission rate is so commonplace that many consumers believe it is non-negotiable, though state law dictates that these fees are absolutely subject to negotiation.  The relative lack of price competition (compared to other industries) has been well documented by the US GAO as well as the Justice Department Antitrust Division.   But my concern goes beyond the level of competition in the marketplace — my issue is with the entire commission model itself.

In the commission model, there is a disconnect between fees and effort. To understand it, let’s examine how the commission model works.  Fees are calculated (ignoring rebates and other transaction costs) as a percentage of the sale price of the property:

Commission ($) = Sale Price X Commission Rate

The commission rate is specified in the listing agreement between the seller and their agent before a house is put on the market.  When the property sells, that commission is paid to to the listing broker who then pays an agreed percentage to the buyer’s broker (as specified in the Multiple Listing Service agreements), and the agents of each broker receive a share of their respective brokers’ take.

Here’s an illustration: take a home that is sold for $500,000.  The listing agreement indicates that the commission rate is 6% and that it will be shared equally between the listing and buyer’s brokers — in this example, each brokerage will then receive $15,000 in commission to be shared with their agents.

The “simplicity” of the commission formula neglects variables such as:

• Number of hours expended by agent
• Value of the agent’s time (measured in terms of $ per hour)

This means that the amount of money paid to agents is calculated without any consideration of the actual amount of effort expended or value provided by the agents involved in the transaction.

Take the brokerage representing the buyer - let’s say it took 100 solid hours of effort to close that transaction; that would mean you paid that brokerage $150 per hour for its services.  But if the process took only 50 hours of solid effort (still more than a standard work week doing nothing else), then you paid $300 per hour!  And what if you have a very desirable property because of location or school district or proximity to amenities, and the process only took 15 hours of solid effort? You just paid $1000 an hour!

To be fair, many agents do a wonderful job for their clients. However, as we can see from the illustration above, the rational economic choice for an agent in the commission model is to do the least amount of work possible per transaction.

There is a more insidious angle here.  In the commission model, the agent’s incentive to get the client to close a deal — any deal — as soon as possible.  Why?  Imagine a property for sale where the total commission is 6%, with 3% going to the buyer’s broker.  For every $10,000 more or less in a property’s sale price (a big swing to most of us), the listing broker’s fee goes up or down by only $300.  For any variance in the final sale price, therefore, the impact to the broker/agent’s commission is two orders of magnitude less than to the client’s pocket.  So, every extra hour your listing agent spends to increase your selling price actually decreases his/her effective hourly rate.  Since the increase in total commission is negligible, the agent’s preference is for you to negotiate less and quickly close a deal.  If you don’t believe that this has a real impact on behavior, check out the Levitt/Syverson study measuring how a real estate agent treats the sale of his/her home versus that of a client.  Again, the commission model introduces these major, unnecessary conflicts of interest.

It doesn’t have to be this way.  A key element of the SmithAdams business model is to provide a fee-for-service alternative to the commission model used by traditional real estate firms.  I believe my approach addresses the flaws described above.  I look forward to discussing this with you.